Staff Site Universitas Negeri Yogyakarta

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Adeng Pustikaningsih, M.Si.

Dosen Jurusan Pendidikan Akuntansi Fakultas Ekonomi

Universitas Negeri Yogyakarta

CP: 08 222 180 1695

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PREVIEW OF CHAPTER

Intermediate Accounting IFRS 2nd Edition

Kieso, Weygandt, and Warfield

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5. Understand the accounting for equity investments at fair value.

6. Explain the equity method of

accounting and compare it to the fair value method for equity investments. 7. Discuss the accounting for impairments

of debt investments.

8. Describe the accounting for transfer of investments between categories.

After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

1. Describe the accounting

framework for financial assets.

2. Understand the accounting for debt investments at amortized cost.

3. Understand the accounting for debt investments at fair value.

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ACCOUNTING FOR FINANCIAL ASSETS

Financial Asset

 Cash.

 Equity investment of another company (e.g., ordinary or

preference shares).

 Contractual right to receive cash from another party

(e.g., loans, receivables, and bonds).

IASB requires that companies classify financial assets into two measurement categories—amortized cost and fair value—

depending on the circumstances.

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Measurement Basis

—

A Closer Look

IFRS requires that companies measure their financial assets based on two criteria:

 Company’s business model for managing its financial assets; and

 Contractual cash flow characteristics of the financial asset.

Only debt investments such as receivables, loans, and bond investments that meet the two criteria above are recorded at amortized cost. All other debt investments are recorded and reported at fair value.

ACCOUNTING FOR FINANCIAL ASSETS

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Measurement Basis

—

A Closer Look

Equity investments are generally recorded and reported at fair value.

ACCOUNTING FOR FINANCIAL ASSETS

LO 1

ILLUSTRATION 17-1

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After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

1. Describe the accounting framework for financial assets.

2. Understand the accounting for debt investments at amortized cost.

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DEBT INVESTMENTS

Debt investments

are characterized by contractual payments

on specified dates of

 principal and

 interest on the principal amount outstanding.

Companies measure debt investments at

 amortized cost or

 fair value.

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Illustration: Robinson Company purchased €100,000 of 8% bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020 and yield 10%; interest is payable each July 1 and January 1. Robinson records the investment as follows:

January 1, 2015

Debt Investments 92,278

Cash 92,278

Debt Investments

—

Amortized Cost

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Debt Investments

—

Amortized Cost

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Cash 4,000

Debt Investments 614

Interest Revenue 4,614

Debt Investments

—

Amortized Cost

LO 2

ILLUSTRATION 17-2

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Interest Receivable 4,000

Interest Revenue 4,645

Debt Investments

—

Amortized Cost

LO 2

Because Robinson is on a calendar-year basis, it accrues

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Reporting of Bond Investment at Amortized Cost

ILLUSTRATION 17-3

Debt Investments

—

Amortized Cost

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ILLUSTRATION 17-2

Assume that Robinson Company sells its investment on November 1, 2017, at 99¾ plus accrued interest. Robinson records this discount amortization as follows:

(€783 x 4/6 = €522)

LO 2

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Computation Gain on Sale of Bonds

Cash 102,417

Interest Revenue (4/6 x €4,000) 2,667

Gain on Sale of Debt Investments 3,557

ILLUSTRATION 17-4

Debt Investments

—

Amortized Cost

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After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

3. Understand the accounting for debt investments at fair value.

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Debt investments at fair value follow the same

accounting entries as debt investments held-for-collection

during the reporting period. That is, they are recorded at

amortized cost.

However, at each reporting date, companies

 Adjust the amortized cost to fair value.

 Any unrealized holding gain or loss reported as part of

net income (fair value method).

Debt Investments

—

Fair Value

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Illustration: Robinson Company purchased €100,000 of 8

percent bonds of Evermaster Corporation on January 1, 2015, at a discount, paying €92,278. The bonds mature January 1, 2020, and yield 10 percent; interest is payable each July 1 and January 1.

The journal entries in 2015 are exactly the same as those for amortized cost.

Debt Investments

—

Fair Value

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Entries are the same as those for amortized cost.

Debt Investments

—

Fair Value

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To apply the fair value approach, Robinson determines that, due to a decrease in interest rates, the fair value of the debt investment increased to €95,000 at December 31, 2015.

Fair Value Adjustment 1,463

Unrealized Holding Gain or Loss—Income 1,463

Debt Investments

—

Fair Value

LO 3

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Debt Investments

—

Fair Value

LO 3

ILLUSTRATION 17-6

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At December 31, 2016, assume that the fair value of the Evermaster debt investment is €94,000.

Debt Investments

—

Fair Value

LO 3

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Debt Investments

—

Fair Value

LO 3

ILLUSTRATION 17-8

Financial Statement Presentation

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Assume now that Robinson sells its investment in Evermaster bonds on November 1, 2017, at 99 ¾ plus accrued interest. The only difference occurs on December 31, 2017. Since the bonds are no longer owned by Robinson, the Fair Value Adjustment account should now be reported at zero. Robinson makes the following entry to record the elimination of the valuation account.

Fair Value Adjustment 925

Unrealized Holding Gain or Loss—Income 925

Debt Investments

—

Fair Value

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Income Effects on Debt

Investment (2015-2017)

Illustration 17-9

Debt Investments

—

Fair Value

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Illustration (Portfolio): Wang Corporation has two debt

investments accounted for at fair value. The following illustration identifies the amortized cost, fair value, and the amount of the unrealized gain or loss.

Debt Investments

—

Fair Value

LO 3

ILLUSTRATION 17-10

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Illustration (Portfolio): Wang makes an adjusting entry at December 31, 2015 to record the decrease in value and to record the loss as follows.

Debt Investments

—

Fair Value

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Illustration (Sale of Debt Investments): Wang Corporation sold the Watson bonds (from Illustration 17-10) on July 1, 2016, for ¥90,000, at which time it had an amortized cost of ¥94,214.

Cash 90,000

Loss on Sale of Debt Investments 4,214

Debt Investments

—

Fair Value

LO 3

ILLUSTRATION 17-11

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Wang reports this realized loss in the “Other income and

expense” section of the income statement. Assuming no other

purchases and sales of bonds in 2016, Wang on December 31, 2016, prepares the information:

Debt Investments

—

Fair Value

LO 3

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Wang records the following at December 31, 2016.

Debt Investments

—

Fair Value

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Debt Investments

—

Fair Value

LO 3

ILLUSTRATION 17-13

Reporting of Debt

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After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

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Companies have the option to report most financial assets at

fair value. This option

 _{is applied on an instrument-by-instrument basis and}

 is generally available only at the time a company first

purchases the financial asset or incurs a financial liability.

Fair Value Option

If a company chooses to use the fair value option, it

measures this instrument at fair value until the company no longer has ownership.

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Illustration: Hardy Company purchases bonds issued by the German Central Bank. Hardy plans to hold the debt investment until it matures in five years. At December 31, 2015, the

amortized cost of this investment is €100,000; its fair value at December 31, 2015, is €113,000. If Hardy chooses the fair value option to account for this investment, it makes the following entry at December 31, 2015.

Debt Investment (German bonds) 4,537

Fair Value Option

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Summary of Debt Investment Accounting

LO 4

ILLUSTRATION 17-14

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accounting and compare it to the fair value method for equity investments.

7. Discuss the accounting for impairments of debt investments.

After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

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EQUITY INVESTMENTS

Equity investment

represents ownership of ordinary,

preference, or other capital shares.

 _{Cost includes price of the security.}

 Broker’s commissions and fees are recorded as expense.

The degree to which one corporation (investor) acquires an interest in the common stock of another corporation

(investee) generally determines the accounting treatment for the investment subsequent to acquisition.

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ILLUSTRATION 17-15

Levels of Influence

Determine Accounting Methods

EQUITY INVESTMENTS

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Illustration 17-16

Accounting and Reporting for Equity Investments by Category

EQUITY INVESTMENTS

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Under

IFRS

, the presumption is that equity investments are

held-for-trading

.

General accounting and reporting rule:

 Investments valued at fair value.

 Record unrealized gains and losses in net income.

EQUITY INVESTMENTS

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EQUITY INVESTMENTS

LO 5

Holdings of Less Than 20%

IFRS allows companies to classify some equity investments

as non-trading.

General accounting and reporting rule:

 Investments valued at fair value.

 Record unrealized gains and losses in other

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Illustration: November 3, 2015, Republic Corporation purchased ordinary shares of three companies, each investment representing less than a 20 percent interest. shares are held-for-trading.

Republic records these investments as follows:

Equity Investments

—

Trading (Income)

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Equity

Investments

—

Trading

Republic records these investments as follows:

Equity Investments 718,550

Cash 718,550

On December 6, 2015, Republic receives a cash dividend of

€4,200 on its investment in the ordinary shares of Nestlé.

Cash 4,200

Dividend Revenue 4,200

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At December 31, 2015, Republic’s equity investment portfolio has the carrying value and fair value shown.

Equity Investments

—

Trading (Income)

LO 5

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Equity Investments

—

Trading (Income)

LO 5

ILLUSTRATION 17-17

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On January 23, 2016, Republic sold all of its Burberry ordinary shares, receiving €287,220.

Cash 287,220

Equity Investments 259,700 Gain on Sale of Equity Investment 27,520

Equity Investments

—

Trading (Income)

LO 5

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In addition, assume that on February 10, 2016, Republic purchased

€255,000 of Continental Trucking ordinary shares (20,000 shares

€12.75 per share), plus brokerage commissions of €1,850.

Republic’s equity investment portfolio as of December 31, 2016.

Equity Investments

—

Trading (Income)

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LO 5

ILLUSTRATION 17-19

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The accounting entries to record non-trading equity

investments are the same as for trading equity investments, except for recording the unrealized holding gain or loss.

Report the unrealized holding gain or loss as other comprehensive income.

Equity Investments

—

Non-Trading (OCI)

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Illustration: On December 10, 2015, Republic Corporation purchased 1,000 ordinary shares of Hawthorne Company for

€20.75 per share (total cost €20,750). The investment represents less than a 20 percent interest. Hawthorne is a distributor for

Republic products in certain locales, the laws of which require a minimum level of share ownership of a company in that region. The investment in Hawthorne meets this regulatory requirement. Republic accounts for this investment at fair value.

Equity Investments 20,750

Cash 20,750

Equity Investments

—

Non-Trading (OCI)

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On December 27, 2015, Republic receives a cash dividend of

€450 on its investment in the ordinary shares of Hawthorne Company. It records the cash dividend as follows.

Cash 450

Dividend Revenue 450

Equity Investments

—

Non-Trading (OCI)

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At December 31, 2015, Republic’s investment in Hawthorne has the carrying value and fair value shown.

Unrealized Holding Gain or Loss—Equity 3,250

Equity Investments

—

Non-Trading (OCI)

LO 5

Computation of Fair Value Adjustment—Non-Trading Equity Investment (2015)

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ILLUSTRATION 17-21

Equity Investments

—

Non-Trading (OCI)

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On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500.

Equity Investments

—

Non-Trading (OCI)

LO 5

Adjustment to Carrying Value of Investment

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On December 20, 2016, Republic sold all of its Hawthorne Company ordinary shares receiving net proceeds of €22,500.

Cash 22,500

Equity Investments 20,750 Fair Value Adjustment 1,750

Equity Investments

—

Non-Trading (OCI)

LO 5

Adjustment to Carrying Value of Investment

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6. Explain the equity method of

accounting and compare it to the value method for equity

7. Discuss the accounting for impairments of debt investments.

After studying this chapter, you should be able to:

Investments

17

LEARNING OBJECTIVES

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An investment (direct or indirect) of 20 percent or more of the voting shares of an investee should lead to a presumption that in the absence of evidence to the contrary, an investor has the ability to exercise significant influence over an investee.

In instances of “significant influence,” the investor must

account for the investment using the equity method.

Holdings Between 20% and 50%

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Equity Method

Record the investment at cost and subsequently adjust

the amount each period for

 the investor’s proportionate share of the earnings

(losses) and

 dividends received by the investor.

If investor’s share of investee’s losses exceeds the carrying amount

of the investment, the investor ordinarily should discontinue applying the equity method.

Holdings Between 20% and 50%

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17-60 LO 6 ILLUSTRATION 17-23

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Controlling Interest

- When one corporation acquires a voting

interest of more than 50 percent in another corporation.

 Investor is referred to as the parent.

 Investee is referred to as the subsidiary.

 Investment in the subsidiary is reported on the parent’s

books as a long-term investment.

 Parent generally prepares consolidated financial

statements.

Holdings of More Than 50%

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accounting and compare it to the fair value method for equity investments.

7. Discuss the accounting for

impairments of debt investments.

Investments

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LEARNING OBJECTIVES

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For debt investments, a company uses the impairment test to

determine whether “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.”

This impairment loss is calculated as the difference between the carrying amount plus accrued interest and the expected future

cash flows discounted at the investment’s historical effective -interest rate.

Impairment of Value

OTHER REPORTING ISSUES

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Illustration: At December 31, 2014, Mayhew Company has a debt investment in Bao Group, purchased at par for ¥200,000

(amounts in thousands). The investment has a term of four years, with annual interest payments at 10 percent, paid at the end of each year (the historical effective-interest rate is 10 percent). This debt investment is classified as held-for-collection.

Using the following information record the loss on impairment.

Impairment of Value

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Loss on Impairment 12,680

Impairment of Value

LO 7

Investment Cash Flows

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If subsequently the impairment loss decreases, some or all of the previously recognized impairment loss shall be reversed with a

 debit to the Debt Investments account and

 crediting Recovery of Impairment Loss.

Reversal of impairment losses shall not result in a carrying

amount of the investment that exceeds the amortized cost that would have been reported had the impairment not been

recognized.

Recovery of Impairment Loss

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8. Describe the accounting for of investments between

Investments

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LEARNING OBJECTIVES

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Transferring an investment from one classification to another

 Should occur only when the business model for managing the investment changes.

 IASB expects such changes to be rare.

 Companies account for transfers between classifications

prospectively, at the beginning of the accounting period after the change in the business model.

Transfers Between Categories

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Illustration: British Sky Broadcasting Group plc (GBR) has a

portfolio of debt investments that are classified as trading; that is, the debt investments are not held-for-collection but managed to profit from interest rate changes. As a result, it accounts for these investments at fair value. At December 31, 2014, British Sky has the following balances related to these securities.

Transfers Between Categories

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Illustration: As part of its strategic planning process, completed in the fourth quarter of 2014, British Sky management decides to move from its prior strategy—which requires active

management—to a held-for-collection strategy for these debt investments. British Sky makes the following entry to transfer these securities to the held-for-collection classification.

Transfers Between Categories

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Reporting Treatment of Investments

LO 8

ILLUSTRATION 17-26

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INVESTMENTS

Before the IASB issued IFRS 9, the accounting and reporting for investments under IFRS and U.S. GAAP were for the most part very similar. However, IFRS 9 introduces new investment classifications and increases the situations when investments are accounted for at fair value.

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Relevant Facts

Following are the key similarities and differences between U.S. GAAP and IFRS related to investments.

Similarities

• U.S. GAAP and IFRS use similar classifications for trading investments.

• The accounting for trading investments is the same between U.S. GAAP and IFRS. Held-to-maturity (U.S. GAAP) and held-for-collection investments are accounted for at amortized cost. Gains and losses on some investments are reported in other comprehensive income.

• U.S. GAAP and IFRS use the same test to determine whether the equity method of accounting should be used, that is, significant influence with a general guide of over 20 percent ownership.

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Relevant Facts

Similarities

• U.S. GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income.

• The measurement of impairments is similar under U.S. GAAP and IFRS.

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Relevant Facts

Differences

• While U.S. GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (only for debt investments), IFRS uses held-for-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications.

• Under U.S. GAAP, a bipolar approach is used to determine consolidation, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting-interest approach. The basis for consolidation under IFRS is control. However, under both systems, for consolidation to occur, the investor company must generally own 50 percent of another company.

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Relevant Facts

Differences

• While the measurement of impairments is similar under U.S. GAAP and IFRS, U.S. GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. IFRS allows reversals of impairments of held-for-collection investments.

• While U.S. GAAP and IFRS are similar in the accounting for the fair value option, one difference is that U.S. GAAP permits the fair value option for equity method investments; IFRS does not.

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On the Horizon

At one time, both the FASB and IASB indicated that they believed that all financial instruments should be reported at fair value and that changes in fair value should be reported as part of net income. However, IFRS 9 indicates that the IASB believes that certain debt investments should not be reported at fair value. The IASB’s decision to issue new rules on investments, earlier than the FASB has completed its deliberations on financial instrument accounting, could create obstacles for the Boards in converging the accounting in this area.

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Financial instruments that derive their value from values of other assets (e.g., ordinary shares, bonds, or commodities).

Three types of derivatives:

1. Financial forwards or financial futures.

2. Options.

3. Swaps.

DEFINING DERIVATIVES

APPENDIX

17A

ACCOUNTING FOR DERIVATIVE INSTRUMENTS

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WHO USES DERIVATIVES, AND WHY?



Producers and Consumers



Speculators and Arbitrageurs

APPENDIX

17A

ACCOUNTING FOR DERIVATIVE INSTRUMENTS

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BASIC PRINCIPLES IN ACCOUNTING FOR

DERIVATIVES

 Recognize derivatives in the financial statements as

assets and liabilities.

 Report derivatives at fair value.

 _{Recognize gains and losses resulting from speculation in}

derivatives immediately in income.

 Report gains and losses resulting from hedge

transactions differently, depending on the type of hedge.

APPENDIX

17A

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17-81 LO 11 Describe the accounting for derivative financial instruments.

Derivative Financial Instrument (Speculation)

Illustration: Assume that the company purchases a call option

contract on January 2, 2015, when Laredo shares are trading at €100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo shares at an option price of €100 per share. The option expires on April 30, 2015. The company purchases the call option for €400 and makes the following entry.

Call Option 400

Cash 400

Option Premium

Jan. 2, 2015

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The option premium consists of two amounts. ILLUSTRATION 17A-1

Option Premium Formula

Intrinsic value is the difference between the market price and the preset strike price at any point in time. It represents the amount realized by the option holder, if exercising the option immediately. On January 2, 2015, the intrinsic value is zero because the market price equals the preset strike price.

APPENDIX

17A

Derivative Financial Instrument (Speculation)

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Time value refers to the option’s value over and above its intrinsic value.

Time value reflects the possibility that the option has a fair value greater than zero. How? Because there is some expectation that the price of

Laredo shares will increase above the strike price during the option term. As indicated, the time value for the option is €400.

APPENDIX

17A

Derivative Financial Instrument (Speculation)

The option premium consists of two amounts. ILLUSTRATION 17A-1

Option Premium Formula

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Additional data available with respect to the call option:

On March 31, 2015, the price of Laredo shares increases to €120 per

share. The intrinsic value of the call option contract is now €20,000.

That is, the company can exercise the call option and purchase 1,000

shares from Baird Investment for €100 per share. It can then sell the

shares in the market for €120 per share. This gives the company a gain

on the option contract of ____________.€20,000 ₍_€_{120,000 -} _€_100,000)

APPENDIX

17A

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On March 31, 2015, it records the increase in the intrinsic value of the option as follows.

Call Option 20,000

A market appraisal indicates that the time value of the option at March 31, 2015, is €100. The company records this change in value of the option as follows.

Call Option (€400 - €100) 300

APPENDIX

17A

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At March 31, 2015, the company reports the

 call option in its statement of financial position at fair value of

€20,100.

 unrealized holding gain which increases net income.

 loss on the time value of the option which decreases net income.

APPENDIX

17A

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On April 16, 2015, the company settles the option before it

expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of €5,000 ([€20 - €15]) x 1,000) as follows.

Call option 5,000

The decrease in the time value of the option of €40 (€100 - €60) is recorded as follows.

Call Option 40

APPENDIX

17A

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17-88

At the time of the settlement, the call option’s carrying value is

as follows.

Settlement of the option contract is recorded as follows.

Cash 15,000

Loss on Settlement of Call Option 60

Call Option 15,060

APPENDIX

17A

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Summary effects of the call option contract on net income.

The company records the call option in the statement of financial position on March 31, 2015. Furthermore, it reports the call option at fair value, with any gains or losses reported in income.

APPENDIX

17A

ILLUSTRATION 17A-2

Effect on Income Derivative Financial Instrument

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Differences between Traditional and Derivative

Financial Instruments

A derivative financial instrument has the following three basic characteristics.

1. Instrument has (1) one or more underlyings and (2) an identified payment provision.

2. Instrument requires little or no investment at the inception of the contract.

3. Instrument requires or permits net settlement.

APPENDIX

17A

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Features of Traditional and Derivative Financial Instruments

APPENDIX

17A

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DERIVATIVES USED FOR HEDGING

Hedging:

The use of derivatives to offset the negative impacts of changes in interest rates or foreign currency exchange rates.

IFRS allows special accounting for two types of hedges—

 fair value and

 cash flow hedges.

APPENDIX

17A

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Fair Value Hedge

A company uses a derivative to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized commitment.

Companies commonly use several types of fair value hedges.

 interest rate swaps

 put options

LO 12 Explain how to account for a fair value hedge.

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Illustration: On April 1, 2015, Hayward Co. purchases 100

ordinary shares of Sonoma Company at a market price of €100 per share. Due to a legal requirement, Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investment as a non-trading equity investment.

Hayward records this investment as follows.

Equity investments 10,000

Cash 10,000

APPENDIX

17A

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Unrealized Holding Gain or Loss—Equity 2,500 Illustration: Fortunately for Hayward, the value of the Sonoma shares increases to €125 per share during 2015. On

December 31, 2015, Hayward records the gain on this investment as follows.

APPENDIX

17A

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Hayward reports the Sonoma investment in its statement of financial position.

APPENDIX

17A

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Hayward is exposed to the risk that the price of the Sonoma shares will decline. To hedge this risk, Hayward locks in its gain on the Sonoma investment by purchasing a put option on 100 shares of Sonoma shares.

Illustration: Hayward enters into the put option contract on January 2, 2016, and designates the option as a fair value hedge of the Sonoma investment. This put option (which

expires in two years) gives Hayward the option to sell Sonoma shares at a price of €125. Since the exercise price equals the current market price, no entry is necessary at inception of the put option.

APPENDIX

17A

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Illustration: At December 31, 2016, the price of the Sonoma shares has declined to €120 per share. Hayward records the following entry for the Sonoma investment.

Fair Value Adjustment 500

APPENDIX

17A

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Illustration: The following journal entry records the increase in value of the put option on Sonoma shares on December 31, 2016.

Put Option 500

APPENDIX

17A

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Financial Statement Presentation of Fair Value Hedge

APPENDIX

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ILLUSTRATION 17B-5

ILLUSTRATION 17B-6

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Cash Flow Hedge

Used to hedge exposures to cash flow risk, which results from the variability in cash flows.

Reporting:

 Fair value on the statement of financial position.

 Gains or losses in equity, as part of other comprehensive income.

LO 13 Explain how to account for a cash flow hedge.

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Illustration: In September 2015 Allied Can Co. anticipates

purchasing 1,000 metric tons of aluminum in January 2016. As a result, Allied enters into an aluminum futures contract. In this case, the aluminum futures contract gives Allied the right and the

obligation to purchase 1,000 metric tons of aluminum for ¥1,550 per ton (amounts in thousands). This contract price is good until the

contract expires in January 2016. The underlying for this derivative is the price of aluminum. Allied enters into the futures contract on

September 1, 2015. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the

contract price. With the two prices equal, the futures contract has no value. Therefore no entry is necessary.

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Illustration: At December 31, 2015, the price for January

delivery of aluminum increases to ¥1,575 per metric ton. Allied makes the following entry to record the increase in the value of the futures contract.

Futures Contract 25,000

([¥1,575 - ¥1,550] x 1,000 tons)

Allied reports the futures contract in the statement of financial position as a current asset and the gain as part of other comprehensive income.

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Illustration: In January 2016, Allied purchases 1,000 metric tons of aluminum for ¥1,575 and makes the following entry.

Aluminum Inventory 1,575,000

Cash (¥1,575 x 1,000 tons) 1,575,000

At the same time, Allied makes final settlement on the futures contract. It records the following entry.

Cash 25,000

Futures Contract (¥1,575,000 - ¥1,550,000) 25,000

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Effect of Hedge on Cash Flows

ILLUSTRATION 17B-7

There are no income effects at this point. Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory.

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Illustration: Assume that Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2016) is ¥1,700,000. Allied sells the cans in July 2016 for ¥2,000,000, and records this sale as follows.

Cash 2,000,000

Sales Revenue 2,000,000

Cost of Goods Sold 1,700,000

Inventory (Cans) 1,700,000

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Illustration: Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry

to the hedging transaction.

Cost of Goods Sold 25,000

The gain on the futures contract, which Allied reported as part of other

comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is ¥1,550,000.

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OTHER REPORTING ISSUES

LO 14 Identify special reporting issues related to derivative financial instruments that cause unique accounting problems.

Embedded Derivatives

A convertible bond is a hybrid instrument. Two parts:

1. a debt security, referred to as the host security, and

2. an option to convert the bond to shares of common stock, the embedded derivative.

The IASB requires that the embedded derivative and host security be accounted for as a single unit.

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Qualifying Hedge Criteria

Criteria that hedging transactions must meet before requiring the special accounting for hedges.

1. Documentation, risk management, and designation.

2. Effectiveness of the hedging relationship.

3. Effect on reported earnings of changes in fair values or cash flows.

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Summary of Derivative Accounting

ILLUSTRATION 17B-8 APPENDIX

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ACCOUNTING FOR DERIVATIVE

INSTRUMENTS

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DISCLOSURE OF FAIR VALUE INFORMATION:

FINANCIAL INSTRUMENTS

LO 15 Describe required fair value disclosures.

Both

 cost and

 fair value

of all financial instruments must be reported in the notes to the financial statements.

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DISCLOSURE OF FAIR VALUE

Three broad levels related to the measurement of fair values.

 Level 1 is the most reliable measurement because fair value is based on quoted prices in active markets for identical assets or liabilities.

 Level 2 is less reliable; it is not based on quoted market prices for identical assets and liabilities but instead may be based on similar assets or liabilities.

 Level 3 is least reliable; it uses unobservable inputs that reflect the company’s assumption as to the value of the financial

instrument.

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DISCLOSURE OF FAIR VALUE

Companies must provide the following (with special emphasis on Level 3 measurements):

1. Quantitative information about significant unobservable inputs used for all Level 3 measurements.

2. A qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable

inputs disclosed, including interrelationships between inputs.

3. A description of the company’s valuation process.

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DISCLOSURE OF FAIR VALUE

Companies must provide the following (with special emphasis on Level 3 measurements):

4. Any transfers between Levels 1 and 2 of the fair value hierarchy.

5. Information about non-financial assets measured at fair value at amounts that differ from the assets’ highest and best use.

6. The proper hierarchy classification for items that are not recognized on the statement of financial position but are disclosed in the notes to the financial statements.

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